When The Free Market Is Too Free

How fitting that this century's second quest for a free-market utopia should be swamped by the gales of global financial turbulence. Financial markets are both the epitome and the bane of the laissez-faire ideal. They are as frictionless as you please, and thus prone to speculative ruin. The more global they are, the less they are regulated, and hence the more vulnerable to self-inflicted calamity.

While markets in, say, shoes are nicely self-regulating, financial markets are notoriously volatile. Even deep markets are no defense against herd instincts and leverage. In the laissez-faire 1920s, the result was the worst of both worlds--a chronic deflationary undertow coupled with bouts of speculative excess, followed by investor panic and then general depression.

Why both deflation and euphoria? An ungoverned global regime is deflationary because it relies on a gold standard or is operated in the interest of creditors or both. With a gold standard, the supply of gold artificially constrains real growth. In a creditor regime with free capital flows, nations pursue monetary austerity to attract investors. But a laissez-faire economy has no regulatory defense against destabilizing fads. Entire economies can be ruined by speculative bubbles.

Within a nation, government intervention can solve these problems. Macroeconomic policy can counter the deflationary influence of creditors. Regulation can temper speculation. Central-bank activity can contain financial panic. But globally, there is no regulatory institution strong enough to maintain stability.

COMMON GOAL. In principle, the 1944 Bretton Woods pact remedied both speculation and deflation. Fixed exchange rates and limits on capital flows banished speculators from the temple. Central banks and treasuries made occasional changes in parities, but their common goal was stability, not profiteering from chaos. International Monetary Fund and World Bank credits helped shaky nations recover by resuming expansion, not by exporting deflation.

Today's World Bank and IMF, however, are a far cry from their originals, which were anchored by a more powerful U.S. dollar and a more activist U.S. government. With the relative weakening of the dollar and the collapse of fixed exchange rates in the early 1970s, Bretton Woods mutated into its antithesis--a system devoted to resurrecting the reign of speculative capital and to enforcing austerity.

Now, with Asia's collapse and the imminent ruin of Russia, even bearers of conventional wisdom are having second thoughts. Longtime academic champions of free trade, such as Columbia University economist Jagdish N. Bhagwati and Massachusetts Institute of Technology's Paul Krugman, now find that financial flows are different from product flows and are not self-regulating after all. Advocates of exposure to global markets as a way of getting prices right are noticing that financial markets often get prices disastrously wrong and that China and India, which retained capital controls, are riding out the storm. Almost everyone faults the IMF's zeal for austerity. Clinton and Blair are rediscovering the "third way" of markets tempered by regulation.

HANDFUL OF SAND. People are also noticing that one size does not fit all. Russia lacks the civil institutions that are the prerequisite of markets; for Russia, the IMF is proving a dubious financial mentor and a worse democratic tutor. Japan's economy is in a classic Keynesian liquidity trap. The more it tries to stimulate spending, the more its anxious consumers stash away savings. East Asia has myriad structural problems. Generalized austerity only makes things worse, as does imported financial speculation. These countries need respite, not more exposure.

But nobody of real political influence is proposing a solution equal to the problem. Throwing some sand in the gears of speculative financial flows, in Yale economist James Tobin's famous phrase, would help. We could start by taxing short-term financial transactions and creating, as Chile did, a penalty for early withdrawals of investment capital to deter speculators. Both remedies are, of course, anathema to Wall Street, which still worships laissez-faire--except when a large institution fails.

Likewise, a global central bank more in the spirit of the original Bretton Woods could temper financial instability and restore a climate of high growth. But such a bank dominated by the present conventional wisdom or present notables would be worse than nothing. Before we get new institutions, we first need a painful reexamination of the most basic principles of this economic era. That rethinking has barely begun.

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